Why Bank auctioneers will be your guests soon, if you do not service your loans promptly.

 

Have you ever paused to think, why Kenyan Banks of late have been under immense  pressure to ensure every credit facility  given to borrowers are duly serviced ?

If you service a credit facility with any Kenyan Bank, like I do, then probably you have received a text message or a phone call from either a bank collection staff or Bank appointed agency reminding you of the due obligations as a pre-delinquency alert or days past due reminders for facilities already in arrears. Worst still, a considerable number of defaulters have had Bank auctioneers repossess and sell the collateral assets or properties pledged to the Banks as security.

Universally, commercial banks are facing problem of non-repayment of loans. This problem can be overcome through monitoring the behavior of borrowers. Thus, the idea of establishing Credit Reference Bureau (CRB) was conceived in order to assist banks in determining credit worthiness of their borrowers. CRBs allows for credit information sharing among the financial institutions to facilitate assessment of credit requests to mitigate risks of bad debts.

Even though CRBs were implemented in Kenya, and all borrowers either positively or negatively listed, there was still a gap that was never bridged fully, including customers who were already servicing their facilities prior to CRB law implementation and the new crop of borrowers who never had negative CRB listing.

The loan repayment default rates in Kenya has indeed reached the highest level ever, According to Central Bank of Kenya, the ratio of gross non-performing loans to gross loans increased from 9.5 percent in March 2017 to 9.91 percent in June 2017. The increase in the gross non-performing loans was mainly attributable to a challenging business environment.

This skyrocket default is not in isolation; historically the first Kenyan-owned bank to fail, in July 1984, was Rural Urban Credit Finance the major contributor being the Non-performing unsecured Asset Finance loans.

In response, we have seen Banks like Kenya Commercial Bank recently put up vehicles and other collaterals for auctions expected to fetch the bank over Sh304.4 Million to repay defaulted loans.

A lot has been discussed about the reasons why customers default which usually fall under the wider spectrum of the “Five Cs of Credit” including character, capacity, capital, collateral and other conditions used by lenders to gauge the creditworthiness of potential borrowers.

This is done by weighing these five characteristics of the borrower and conditions of the loan, attempting to estimate the chance of default and to put in appropriate mitigation measures. This covers other commonly quoted reasons by default Bank customers including; Unfavorable economic factors, the long political turmoil experienced in Kenya in 2017 among many other reasons.

The current Kenyan Banking sector default rate in my opinion goes beyond the Five Cs of Credit reasons of default; although they may be primary contributors on the customer’s side, I consider the following reasons as the main contributors to this situation.

First is the impact of capping Interest rates on the Banking sector in Kenya. The August 2016 amendment to the Banking Act resulted to two major game changers in the Banking industry: capping of Bank lending rates at 4.0% above the Central Bank Rate (CBR) and set a floor on the deposit rates at 70% of the CBR.

This new law was at the onset palatable news for many customers, as it was meant to deny banks a free hand in deciding what interest to charge on loans. Indeed, it appealed to the masses with stories of Kenyans struggling under heavy debts that accumulated high interest rates as banks basked in the glory of very high profits.

Although this law had a very noble objective, in practice it has ended up with very adverse consequences. The net result has been reduced credit supply and banks compelled to increase their risk mitigation measures which has locked out potential customers below certain risk thresholds on existing products standards.

According to Central Bank data, for the past 20 years, Kenyan banks have been enjoying interest rate spreads of about 11.4% on average; way above the world average of 6.6%.This spread did not only promote fair competition among the Banks but also served as a key factor behind the profit Margins witnessed among the Kenyan Banks hitherto.

With the profit Margins diluted, Banks have therefore put up very stringent loans collections and remedial measures to recover every cent owed by borrowers peradventure their profit margins be cushioned further.

I believe banks need to continue being innovative in their efforts to remain in business. Banks, which have the capacity to diversify into areas such mobile Banking, agency and other non-funded income streams like Banks Guarantees and Letters of Credit will definitely continue to record growth in the income derived from these businesses.

Further, I concur with the current Central Bank of Kenya governor, who has consistently expressed His reservations on interest rates cap law terming it as a ‘dangerous development’.

As the negative impact of the capping crystallises in the Banking sector and as History has shown repeatedly that once the doors of liberalisation and open markets are opened, trying to close them create far more destructive and disruptive effects in the economy is becoming a reality.

The solution in my opinion should have been and still is lies with the liberalisation of the interest rate regimes. This should be accompanied by strong regulatory resolve and visionary leadership by the Government of Kenya, the Central bank of Kenya and the Kenya Association of Bankers to mitigate the extreme invariably of the interest rates caused by free market dynamics.

Secondly is the impact of regulatory pressure for Bad debt provisioning by the Central Bank of Kenya prudential guideline on risk classification of assets, provisioning and limitation on Interest recoverable on non-performing loans (CBK/PG/04).

This guideline is intended to ensure that all assets are regularly evaluated using an objective internal banking grading system which is consistent with this guideline and to ensure timely and adequate provisions and write offs are made to the provisions account in order to accurately reflect the true and fair financial condition of the institutions.

It requires institutions to maintain adequate provisions for bad and doubtful debts prior to declaring profits or dividends, exchange information on non-performing loans and limits the amount of interest institutions may recover on non-performing loans.

The strict implementation of the regulatory directive to classify loans correctly forced banks to set aside money for Non-Performing Loans (NPL) with principal or interest repayments falling due and unpaid for 90 days or more; or interest payments for 90 days or more have been re-financed, or rolled-over into a new loan. This has had a notable negative impact on the profitability of most Kenyan Banks.

From 2015 to date, banks have continued to report a record high volume of toxic loans as the Central Bank of Kenya moved in to enforce its prudential guidelines.

Most of the big lenders, more than doubled their provisions for non-performing loans between 2014 and 2016. For the first three months of 2016 alone, banks experienced a Sh36.6 billion rise in bad loans, which was a 10-year high.

NIC Bank for example recorded a five per cent dip in net earnings after setting aside Sh3.1 billion for NPLs. The bank reported a Sh3.4 billion after-tax profit for the period ending September 30, 2016 compared to Sh3.6 billion in 2015. During the same period Barclays Bank of Kenya posted Sh6 billion in profit, down from Sh6.4 billion after bad debts rose to Sh10.4 billion, prompting it to set aside Sh4.5 billion as provisioning. Bad loans stood at Sh6.9 billion in 2015.

I opinion that for long term solution, Kenyan Banks should not just be content with traditional credit risk measures such as exposure limits and credit rating, but should reinitiate a process of overhauling the entire system of risk management.Banks should move towards Risk-Adjusted Return on Capital framework for appraising loans, which calls for data on portfolio behavior and allocation of capital commensurate with credit risk inherent in loan proposals.

Over and above these prudential guidelines, I believe for long-term sustainable solutions, Central Bank should constructively crack the whip on the issue of risk management. We need to contentualise and implement Basel Committee on Bank Supervision accords (BASEL 2 and 3) which incorporates credit risk of assets held by financial institutions to determine regulatory capital ratios.

Thirdly is the inadequacies of the International Accounting Standard 39 on handling credit risk.

The International Accounting Standard 39(IAS39) is a global accounting tool developed by International Accounting Standards Board (IASB) with the aim of prescribing unified rules for reporting of the financial instruments so that companies presented them in a transparent and a consistent way.

The financial crisis of 2007–2008 considered by many economists to have been the worst financial crisis since the Great Depression of the 1930s revealed a major credit risk challenge, which IAS 39 has been unable to effectively mitigate- delayed recognition of credit losses that are associated with loans and other financial instruments.

This weakness resulted in ‘too little, too late’ – too few credit losses being recognised at too late a stage. IAS 39’s is based on ‘incurred loss’ model delayed the recognition of impairment until objective evidence of a credit loss event had been identified, i.e., credit losses are not recognised until a credit loss event occurs. Under this accounting standard, impairment losses are recognised only upon the occurrence of a credit event of the issuer, even if this was expected to happen.

The crisis began in 2007 with a crisis in the subprime mortgage market in the US, and developed into a full-blown international banking crisis with the collapse of the investment bank Lehman Brothers on September 15, 2008. Excessive credit risk-taking by banks such as Lehman Brothers helped to magnify the financial impact globally. Massive bailouts of financial institutions and other monetary and fiscal policies were employed to prevent a possible collapse of the world financial system.

As the financial crisis unfolded worldwide, it became clear that the incurred loss model gave room to a different kind of earnings management, namely to postpone losses. Even though IAS 39 did not require waiting for actual default before impairment is recognized, in practice this was often the case.

During this same period Kenya, experienced financial crisis in 2008 and 2009, which prompted the Country to pursue expansionary monetary and fiscal policies, among others, to deal with the crises.

I believe the delayed recognition of credit losses that are associated with loans and other financial instruments weakness of the International Accounting Standard 39 has finally caught up with the Kenyan Banking industry, being one of the factors behind the repayment default rate upwards trend.

The IASB has therefore published a new International Financial Reporting Standard 9 (IFRS 9) to address the shortcomings by mandating a new method for applying risk metrics to accounting relating to the Financial Instruments. Published in July 2014, the IFRS 9 will come into effect on 01 January 2018 and covers the simplification of classification and measurement categories, move from Incurred loss to expected loss model with an improved Hedge accounting model.

This expected loss impairment model will be more responsive to changes in credit risk as it requires recognition of full time expected losses even at inception, such as when a loan is first granted and In addition, address the widespread criticisms of ‘too little, too late’.

As a solution, the Expected Loss Model under IFRS 9 is a forward-looking model that will result in more timely recognition of loan losses and is a single model that is applicable to all financial instruments subject to impairment accounting. It will eliminates the threshold for the recognition of expected credit losses, so that it is no longer necessary for a trigger event to have occurred before credit losses are recognized. Consequently, more timely information is required to be provided about expected credit losses.

With the implimentation of this new accounting standard, the IFRS9 in January 2018, we expect Banks bad loan loss provisioning figures to increase and profitability to even dip further.we will most probably witness stringent lending regimes, heightened credit recovery efforts and massive cost cutting measures by Banks.

In conclusion, the banking industry in Kenya needs to recover from the current repayment default as a matter of urgency. A lot is being said but it is claimed not enough action has been taken compared to what is happening in the industry. I do not think there a single solution to this problem. However, I have suggested several measures that can significantly reduce the incident of each of the factors underlying the crises. Additionally greater macroeconomic stability, the wider use of market-based hedging instruments and higher levels of bank capital would help to make the consequences for the domestic banking system less damaging.

Limiting the allocation of bank credit to particularly interest-rate-sensitive sectors, close monitoring of lending and employing the right mix of macroeconomic and exchange rate policies would similarly limit credit vulnerability, asset price collapses and surges of capital inflows to help customers prudently service their debt obligation.